Founders vs. Early Employees

To help with this discussion, let me start with a definition of "early employee." Steve Blank divides the individuals associated with startups as:

Founders

Early Employees (Employees # 1-25)

Later Employees (Employees # 26-125)

The reality is that the definition of founder and employee is not clear. The first few people into a startup are on a spectrum of founder vs. early employee. Founders are likely not paid for a long time and have a sizeable equity percentage for early risk and having the concept. An employee is later, has a greater portion of compensation as cash, has lower risk, and generally does not bring as much to bear in terms of the concept.

Early Employee Equity is an Art

For your first key hires, three, five, maybe as much as ten, you will probably not be able to use any kind of formula. Getting someone to join your dream before it is much of anything is an art not a science.

Equity Formulas

While it's somewhat an art, there has been a lot written about how you can look at equity compensation.

Paul Graham provides what is roughly the core formula for equity at any point in The Equity Equation:

You can use the same formula when giving stock to employees, but it works in the other direction. If i is the average outcome for the company with the addition of some new person, then they're worth n such that i = 1/(1 - n). Which means n = (i - 1)/i.

For example, suppose you're just two founders and you want to hire an additional hacker who's so good you feel he'll increase the average outcome of the whole company by 20%. n = (1.2 - 1)/1.2 = .167. So you'll break even if you trade 16.7% of the company for him.Let's run through an example. Suppose the company wants to make a "profit" of 50% on the new hire mentioned above. So subtract a third from 16.7% and we have 11.1% as his "retail" price. Suppose further that he's going to cost $60k a year in salary and overhead, x 1.5 = $90k total. If the company's valuation is $2 million, $90k is 4.5%. 11.1% - 4.5% = an offer of 6.6%.

Of course, to be able to use this kind of formula, you will need to be able to determine how much impact the person will have and figure out a valuation. I've talked about this topic before in How Investors Think About Valuation of Pre-Revenue Startups, and CTO Salary and Equity Trends 2009-2011. You can also take a look at StartupRoar's topics: Startup Valuation, Pre-Money Valuation, and Early Stage Valuation.

Same Value for Sweat Equity as Investment Dollars?

Jason Cohen in How to think about cash vs. equity compensation (definitely read the comments) provides similar kinds of formulas. The key in his approach is that equity compensation should be viewed the same way that you view investment. In other words, the loss of compensation for the early employee as compared to market rate should be viewed as equivalent to the equity for that same dollar amount from an investor.

Logically, that's correct, but I personally would put a risk premium on equity compensation. I also believe that early employees should be bringing higher value than early investor dollars as they can and should contribute to the concept greater than an investor. They are partially rewarded by the increase in value of their equity. But their contributions raise the value for everyone. I believe that Paul Graham's core formula takes that into account.

The more that those first employees feel like founders in terms of their ownership, emotional attachment, responsibility and overall understanding of the startup process (including financing, running day-to-day activities, etc.) the better the startup will be.

David Beisel puts it another way:

Being an early hire at a startup gives an individual the ability to make tremendous impact on an organization as it grows – and both the founders and those hires should know it.Of course, all of that assumes that the early employee does make an impact.

Risk Premium on Equity Compensation?

While Jason Cohen suggests that investment cash and sweat equity should be viewed the same, quite a few people suggest that there should be a risk premium for early employees at early-stage startups. A risk premium is a multiplier that says that any equity compensation should be viewed as being worth less than cash for that employee because of the risk.

The risk premiums that I've seen vary widely with seemingly camps of:

None - like Jason

20-50%

3x - 4x

In a way, suggesting there should be a risk premium is just arguing over valuation and expected return. There's also the aspect that the equity that you typically get as part of equity compensation is behind other equity in preference and thus effectively has lower value.

But the more important rationale is raised in the following about why employees most often do not have significant outcomes even in fairly positive liquidity events.

Consider the proceeds of a $50-million acquisition for a 100-person company that has raised $14 million with a typical liquidation preference:

Because of the liquidation preference, the investors get $14 million right off the top. The remaining $36 million is divided according to equity ownership.

Investors own 50%, and get $18 million, split between two firms

The two founders own 33%, and split $12 million

The 3-person executive team, including a CEO if one was hired, owns 10%, and splits $3.6 million. The team gets another $3 million as a severance payment or an earn-out, to sweeten the acquisition offer.

The remaining 95 employees split 7%, each earning $27,000. Unlike the founders, the employees have to wait until their grants vest, working at a company no longer of their choosing for two years.

Is it Time for Your to Earn or to Learn?

You get 1%, you sell for $150 million and it’s in 3 years (e.g. you won the lottery). That’s an after-tax gain of $287,500 / year for 2 years. Not bad. Doh! Wait a second. Stock vests for 4 years. You didn’t get acceleration on a change of control? Sorry bud. We’ll have to either cut your earnings in half to $143,750 or you’ll have to complete 2-years at BigCo that bought you making the money spread out over 4 years so it’s $143,750 / year for 4 years.

The reality is that an early employee in a pre-funded startup that eventually raises a few rounds of capital will be diluted significantly, is down the line in preference, and will likely be locked up for a while to harvest it. And that's assuming that it's a fairly positive outcome. If it's anything less that positive, preferences will mean they get nothing other than what's required to keep them working if that's needed at the acquiring company."

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